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Private Equity Part 1

Private Equity (Part I)

Knowledge Check

Welcome to the Knowledge Check. If you have prior knowledge of Private Equity, try the Knowledge Check. A perfect score is no guarantee that you know everything covered in the tutorial, but a less than perfect score will help you identify any knowledge gaps. If the subject of this tutorial is new to you, the Knowledge Check will indicate the level of the information that you're about to encounter. You may think you don't know much about this area, but you might surprise yourself!

Question 1 of 3
What is meant by the concept of 'carried interest'? Amortization of investment costs Interest roll-up with interest on loans payable at the exit stage A private equity fund's share of profits The internal rate of return earned by investors Correct. You will learn about the concept of carried interest or 'carry' in Topic 1, Overview of Private Equity.

Question 2 of 3
What is a BIMBO? A leading private equity firm in the UK A regulation covering management buy-ins and buyouts A combination of a management buy-in and a management buyout Incorrect. You will learn about the different types of private equity investment in Topic 2, Types of Private Equity. The most common method of assessing the success of a private equity investment is to determine the 'internal rate of return (IRR)'. The IRR is the return that would:

maximize the net present value (NPV) of the investment make the NPV of the investment equal to zero maximize the required hurdle rate for the investment enable the investment to achieve the required hurdle rate Incorrect. You will learn about the use of IRR to evaluate private equity investments in Topic 3, Private Equity as an Asset Class.

On completion of this tutorial, you will be able to: describe the basic features of private equity and its development into a significant asset class identify the two main types of private equity investing, namely venture capital and buyouts explain the benefits of investing in private equity as an asset class Prerequisite Knowledge Prior to studying this tutorial, you should have a basic understanding of financial markets and instruments as described in the following tutorial: Financial Markets – An Introduction

What is Private Equity?
Private equity firms provide medium- or long-term financing to companies that are (usually) not quoted on public markets. However, listed companies are increasingly targets for private equity firms and, once acquired, they are promptly de-listed and restructured (perhaps with the intention of re-flotation in the future). In many jurisdictions, public funding for early-stage capital is patchy. The process is more established in the US, where the NASDAQ market has been fostering young companies for several decades. Private equity provides long-term, committed share capital to help unquoted companies grow and succeed. It therefore fills the equity gap, that is, the missing link in accessing public capital as soon as the companies have been nurtured by private capital.

How is Private Equity Different from a Loan?
Obtaining private equity is different from issuing debt or raising a loan from a lender. Lenders have a legal right to interest on a loan and repayment of the capital, which is usually secured over some business assets. Therefore, lenders' return is assured irrespective of the success or failure of the business (ignoring potential issues that arise in the relatively rare event of default). Private equity is invested in exchange for a stake in the company. Therefore, as shareholders, the investors' returns and success are dependent on the growth and profitability of the business.

Private Equity as an Investment
As an asset class, private equity offers potentially high returns on a risk-adjusted basis. The returns are not correlated with traditional investments and, therefore, bring diversification benefits for investors. (We will revisit these important concepts later in the tutorial.) Private equity relates to investors looking to start up, expand, or buy a stake in a business, to buy out a division of a parent company, or to revitalize a company. However, investments can carry high risk due to their long-term nature, the uncertainty of the outcome, and illiquidity. The benefits from private equity investing stretch well beyond the immediate circle of investors, to the workers employed directly or indirectly by the industry itself and the beneficiaries from the high returns earned by the likes of pension fund investors. The economy as a whole also benefits from the long-term job creation resulting from private equity investments (a shorter-term view might be to focus on the loss of jobs resulting from company

restructurings following takeovers by private equity firms) and the establishment of many new, innovative companies.

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Another safeguard for lenders in Asia is a requirement for 75% of the current fund or deal to be funded before embarking on any new private equity deals. private equity investments are frequently done on an unleveraged basis. This is not the case in the US and Europe where firms can initiate new deals before the original deals are funded. with investors depending on high organic growth rather than on financial engineering to earn large returns. a factor that was hit by the global credit market squeeze that commenced in 2007. private equity funding in Asia has less direct exposure to changing interest rates or market conditions. Private equity firms and investment banks were left with billions of dollars of leveraged buyout (LBO) debt on their balance sheets when investors exited the markets in droves.US/European Funds vs. However. Because of these favorable conditions. Therefore. some massive global private equity firms. such as TPG and Kohlberg Kravis Roberts
. Asian Funds
The returns earned by the US and European mega private equity funds have been heavily influenced by the availability of credit. in Asia.

low interest rates. Other investors include banks and other financial institutions.
Private Equity Market
Which is the largest market for private equity investment? United States United Kingdom Europe (excluding the UK) Asia-Pacific Correct. such as pension funds. university foundations.(KKR). with opportunities for takeovers relatively scarce.
Private Equity Investors
With easy credit. sovereign wealth funds (SWFs) grew in importance as providers of funds to private equity firms. the highest percentage of private equity funds invested has been in the US. to invest in private equity. many different types of investor were drawn to the private equity industry to avail of the potential high returns.
. charities. Historically. When pension funds and some other investors scaled back their activity in the face of the global credit market crisis. although the industry is becoming increasingly global. Historically. and knowledgeable private (individual) investors. insurance companies. not-for-profit organizations. The high returns and benefits of diversification have attracted institutional investors. have put together multi-billion dollar funds targeted specifically at buyout deals in Asia. public authorities/public benefit corporations. and booming debt markets creating an attractive environment for leverage. the sizes of private equity deals in Asia have tended to be much smaller than in the US and Europe.

sovereign wealth funds (SWFs)
Sovereign wealth funds (SWFs) are state-owned funds that represent pools of capital gathered together by nations that have managed to accumulate significant currency reserves. These funds are not particularly new (the Abu Dhabi Investment Authority (ADIA). but their influence grew considerably recently as they helped banks to repair the damage to their balance sheets caused by the global credit market crisis.
. widely thought to be the largest SWF. was set up in the mid-1970s).

Historically.Private Equity Manager Fees
What is the typical fee charged by managers of private equity funds? 2% of assets 8-10% of assets 20% of assets Correct.
. although this has been falling in recent years. management fees for private equity firms have been around 2% of assets.

the term 'venture capital' has been used to cover investments done at all stages. but they have shared characteristics.
. in the US. there is a tendency across the globe to use the term 'private equity' generically for all stages. In Europe. The skills and mindset of the categories – venture capital and buyouts – are distinct.Private Equity Types
In general. and 'venture capital' refers only to the investments in early stage and expanding companies. the term 'private equity' has been used to refer only to the buyout and buy-in investment sector. Nowadays.
Historically. there are two main types of private equity.

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Examples of specialist private equity/venture capitalist firms include the 3i Group and Austin Ventures. These entities often raise the capital initially from institutional investors.
.Types of Venture Capitalist
There are different types of venture capital suppliers. who are participants in an informal venture capital market. investment and commercial banks that have established private equity/venture capital subsidiaries. In some quarters. often referred to as 'business angels'. limited partnerships and closely-held corporations that have been formed as specialists in providing venture capital funding. wealthy individuals. they are considered one of the largest sources of all venture capital. including:
traditional wealthy families. such as insurance companies and pension funds. This network of 'angels' is capable of tolerating highrisk investments and rely on each other for advice. such as the Rockefeller family in the US who supplied venture capital for many years.

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the average scenario for a private equity-owned company in the UK is that it is floated after three years for GBP 250 million and the chief executive receives GBP 8. which materializes into wealth on exit. according to Deloitte. including: a large company might decide to divest a part of its business a family-owned business may wish to sell out its stake a business might be struggling and appear undervalued In a buyout. all or part of the incumbent management team is often retained because the team knows the business well and is aware of the risks. The rewards are high. should the business perform well. The managers are incentivized through a stake in the business.5 million.Reasons for Buyouts
There are numerous potential reasons for a buyout.
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Buy-In Management Buyout (BIMBO)
A buy-in management buyout (BIMBO) is a combination of a management buy-in and a management buyout. It occurs when a team consisting of a combination of existing management and
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Private Equity Types
Which of the following statements is true? Generally speaking. backable management alongside the knowledge of the existing management team. MBIs tend to carry higher risk than MBOs. frictions between the new management team and the employees can sometimes arise in practice. However. This combination can provide new.outside managers undertakes a buyout of a company.
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some deals take ten years to come to fruition. private equity investments are judged over a long time frame.Buyouts tend to focus on the early-stage financing in a company's life. First and foremost. For example. such as the provision of seed or start-up capital. there are potentially very high returns.
The J-Curve Effect
The J-curve effect is a term often used in the industry to describe the pattern of returns produced by certain private equity funds that experience negative returns in the early years. Click the Back arrow to try again. the economic scenario can change dramatically and it can be very difficult to predict which private equity investments and funds will be successful. LBOs are always financed by bond issues. Because of the long time frame. As an asset class. Generally. Incorrect.
Private Equity Returns
Private equity has been established as an asset class for over 30 years. Analysis of the past performance of the management team can be an indicator of their skills in realizing profits. but later increase significantly in value.
. it offers a number of attractions. LBOs may be partly financed by borrowings or by a bond issue (senior/subordinated debt). in addition to a sponsor's equity capital.

resulting in realized gains for the investors. Firstly. progress is made until the value of the business exceeds its original cost.In the early years. The following graph shows the annualized 10-year returns (up to the end of 2005) for the US private equity industry compared to quoted investments (stock market indexes) over the same period:
. Over time. private equity firms are secretive by their very nature. resulting in unrealized gains for investors.
Measuring Private Equity Returns
In practice. As explained above. the higher valuation is confirmed by a partial or a complete sale. investors must be willing to 'suffer' a number of years of negative returns. This can prove to be a hard sell for the trustees of (say) a conservative pension fund. Institutional investors sometimes cite the J-curve effect as a reason why it's difficult for them to invest in the private equity asset class. and therefore disclose only minimal information about their strategies. which means that they do not have a readily measurable market value. the underlying investments are generally illiquid and not quoted. True performance is only apparent when the fund is wound up. As the fund nears its termination date. measuring the performance of private equity funds is difficult for a couple of reasons. Secondly. investment returns are negative because: management fees and other expenses must be paid upfront from the committed capital underperforming investments ('lemons') tend to be identified early and written down relative to better performing investments that are often held longer and sold later in the life of a fund It can take a number of years for portfolio valuations to reflect the efforts of the fund managers.

the net return on funds raised between 1980 and 2001 to the end of 2005 was 14% p. This means that capital is invested in 'drawdowns' as opposed to paying it all up front in many traditional investment products. This can be illustrated in a cash flow diagram as shown below:
The IRR is the return that would make the overall net present value (NPV) of the investment equal to zero.
Calculating Internal Rate of Return
Let's look a simple example to illustrate how IRR is calculated.Internal Rate of Return
The most common method of assessing the success of an investment is to determine the internal rate of return (IRR). private equity investors are requested for capital ('capital calls') when opportunities arise to finance companies.
Assessing Returns . according to the British Private Equity & Venture Capital Association (BVCA). the returns achieved by the private equity industry were similar to average returns on stock markets. A Word of Caution A number of private equity firms calculate returns on a gross basis. that is. The actual
. Comparison of fund performance can be useful. The amount of cash flows generated and the time frame are key inputs to the IRR. An investor is investing GBP 300. before the deduction of fees. This can make quite a difference with management fees set around 2%. It also has the impact of increasing returns because the capital does not sit fallow awaiting investment and diluting returns.In the UK.000. and is similar to calculating bond yields.. because at that rate the receipts are equal to the investments. net of all fees including carried interest.000 for the investor. This method calculates the total cash flow return on an investment from inception.565. Usually. and the returns can vary substantially from period to period. The exit from the venture after 10 years is expected to generate GBP 1. The range of returns between the good and bad performers is much wider than for most other asset classes.000 in a private equity fund in three equal annual installments of GBP 100. the average IRR required by a private equity firm on an investment is in the region of 20-25% per annum. As a rough guide. Research from the US suggests that when fees were excluded. but only if comparing like with like with regard to geographical location.a. industry. a lower cash flow receipt could be worth more to an investor if it is received very quickly. and type of fund.

Plugging in the figures from the example above: NPV = -[GBP 100.calculation of IRR involves trial and error using the following formula:
You can also use spreadsheet programs. to perform this calculation. and there are no cash flows received in the interim period.000/(1 + IRR) = 0 Solving this equation yields an IRR value of 20% (there may be very minor rounding differences).565.000 + GBP 100.000/(1 + IRR) ] + GBP 10 1. the inflows are the proceeds realized upon exit from the investment. the IRR equation can be simplified to:
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Alternative Formula for Calculating IRR
Assuming that there is an initial cash outflow at the start of the investment.000/(1 + IRR) + GBP 100. such as Microsoft Excel.

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such as betas. Diversification Risk analysis of quoted portfolios uses indicators. However. within a diversified portfolio. This cannot be applied to private equity portfolios. correlations over the long-term between private equity returns and other asset classes have been very low. in the US market. the potential for a capital loss is extremely unlikely. as indicated in the table. the overall returns for the private equity industry indicate that. Diversification of investment among a range of different private equity funds. A 'diversified portfolio' would be a well-managed portfolio of regular commitments. across a range of managers of different types of private equity fund. For instance. over a number of years. is crucial to reduce risk due to the spread of returns from individual funds. The return of a private equity fund can only be calculated when the fund is wound up.
.Correlation and Diversification
Private equity returns are not highly correlated with the traditional asset classes. nor do they follow the same cycle as equities. which serves to reduce the risk in a portfolio. or through a fund of funds (who invest in a portfolio of private equity funds). where individual stocks can be valued on a daily basis.

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99 Incorrect.
. the inflows are realized upon exit from the investment. and no cash flows are received in the interim period. What is the internal rate of return? Input your answer correct to two decimal places. The investors' initial investment was USD 250 million. As there is an initial cash outflow at the start of the investment.Internal Rate of Return
A private equity fund is able to achieve a residual equity value of USD 500 million after three years.
100
%
Correct Answer: 25. the IRR can be calculated as:
Click the Back arrow to try again.